Despite Lower Preleasing, New Office Buildings Still Offer the Most Upside
Although the amount of office space underway nationally has moderated from a cyclical peak just before the pandemic, an increasing share of that new construction is being built on a speculative basis, with no preleasing, which may present increased risk given higher remote-working rates.
However, despite some challenges in the near term for new unleased office supply, the larger secular shift of tenant demand toward modern, high-quality buildings and the dearth of availability of that type of space in many markets should result in new office space outperforming older properties in attracting credit tenants over the longer term.
Roughly 158 million square feet of new space was underway across 54 major U.S. office markets in the first quarter of 2022, equal to 1.7% of the existing inventory. That marks a decline from 186 million square feet in the first quarter of 2020 and lower than the amount of space that was underway at the peak of the last cycle.
However, while leasing activity nationally in the office market is returning to more normal levels, the preleasing rate for the office space under construction averaged about 64% in the first quarter of 2022, well below the 85% to 87% rates achieved prior to the pandemic and lower than the historical average preleasing rate of 76%. In general, a lower level of preleasing is associated with higher risk.
Due to the recent decline in preleasing, as well as the sluggish demand environment following the pandemic, lease-up rates have fallen for newly completed office projects. Vacancy rates for office buildings completing construction — and in the quarters immediately following — remain elevated for projects completed in the past two years relative to the pre-pandemic average. Vacancy in projects at delivery in 2020 and early 2021 was about 38% compared to about 28% for properties at the time of completion in 2017 to 2019.
However, leasing for newer office properties has continued at a steady rate. On average, after eight quarters from completion, 2020-vintage properties have achieved lease-up rates close to office properties that achieved stabilization before the pandemic.
While sluggish preleasing is a symptom of the overall weaker leasing environment the office sector has experienced in the last couple of years, new space coming online is still expected to garner stronger demand relative to space in older buildings. In an environment where tenants are more discerning about how much square footage they need, a preference for modern, high-quality space prevails as four- and five-star-quality buildings account for a continually rising share of office demand nationally.
This top-quality segment of the office market accounted for 37% of demand in the first quarter of 2022 compared to 31% in 2002. Meanwhile, the share of demand for lower-quality buildings has steadily declined over the past two decades. And with less new office space being built, the amount of modern high-quality space available in the county has declined substantially. Two decades ago, roughly 46% of the national office inventory was less than 20 years old. As of the first quarter of 2022, that share has declined to about 20%.
If office properties currently in lease-up are set aside, newer stabilized properties have consistently remained well occupied, even throughout the pandemic. Average vacancy for office space built from 2010 to 2019 has continued to fall over the past decade to a low of 7.3% in the first quarter of 2022. By contrast, vacancy in older buildings has continued to rise since the start of the pandemic. Office space built in the 1990s and earlier has vacancy languishing above the national average and above levels from 10 years ago.
This trend is also reflected in average annual rent growth. Office properties built in the 1990s or earlier increased rent at an annual average of 2.9% over the past 10 years, lagging the 3.3% annual rent growth of properties built from 2010 to 2019.
Certain markets, particularly those in the Northeast, have a much higher share of older office buildings. As a result, new office construction in those areas may garner stronger demand relative to older existing buildings, even if leasing activity for new space underway is lagging. This clear preference for modern space bodes well for newer office buildings in some of the larger, more mature markets such as New York, Boston, Los Angeles and Chicago, where less than 10% of the office stock has been added since 2010 and two-thirds or more was built over 30 years ago.
Furthermore, newer space is tighter in these markets. Some of the faster growing Southeast and Southwest markets, like Austin, Texas; Charlotte, North Carolina; and Nashville, Tennesee, on the other hand, have much newer stock with upward of 20% of their inventory built since 2010.
The amount of office construction underway and preleasing rates across markets further reveal where leasing of new space may happen faster. Together, New York and Boston account for 20% of all space underway nationally. That’s a high amount to contend with certainly, but the above-average preleasing rate on that new space and the smaller share of new inventory in those markets suggest new projects will continue to lease up.
Other markets such as Austin, Charlotte and Nashville have below-average preleasing rates on in-process construction, and a higher share of their existing office inventory is newer space. This dynamic creates more tenant competition for new buildings coming online in those markets. The three markets also have some of the strongest office employment growth in the country, which will continue to fuel office demand.
Office leasing is rebounding but has yet to consistently register at levels above the pre-pandemic trend. Even when it does, demand is expected to continue to focus on higher-quality buildings, in keeping with historical trends. However, the overall lack of modern, high-quality space that tenants are seeking means that even amid the demand headwinds driven by higher remote-working rates, newer, modern office space is expected to outperform older, outdated peers in the competition for the highest-quality tenants over the long term. Furthermore, office users may continue to trade up to newer space options within markets, so the ultimate laggards will be the functionally obsolete and outdated space, which may be ripe for redevelopment or conversion to different uses.